AIG vs. Madoff clients: Who's scamming whom?

In a story that seems designed to give financial pundits a burst of near-apocalyptic joy, the two most scandal-ridden entities of the past year have come together in a brilliant flash of moral turpitude and slick legal wrangling. In one corner, there's Bernie Madoff, the greatest Ponzi schemer of all time; in the other, there's AIG, the most irresponsible insurer every to receive a massive government bailout. Standing in the middle are Robert and Harlene Horowitz, Madoff customers who want AIG to eat the $8.5 million that they lost to Big Bern.

The Horowitzes' suit, which was filed on Wednesday in the U.S. District Court in Manhattan, alleges that AIG issued them an insurance policy that covered their Madoff investments. At first flush, this lawsuit appears to be a desperate attempt to squeeze a few pennies out of AIG over what must be a misinterpretation. After all, it's hard to imagine an insurer who would be reckless enough to write a blanket policy, sight-unseen, that protects its holders against all financial scams, with no limitations.
However, that is exactly what AIG did. According to this prospectus, AIG's Fraud SafeGuard program, in which the Horowitzes enrolled, insures holders' "money, securities, personal property, jewelry, and collectibles" against identity theft, forgery, check fraud, embezzlement, theft, robbery within 100 feet of an ATM, and telephone schemes. It promises up to $200,000 worth of coverage for as little as $70 per year.

Taken within its broadest possible context, this "homeowners'" policy extends the definition of home -- and insurance -- indefinitely, and covers an unlimited number of scams. What's even more amazing is that, for many Madoff clients, AIG has actually honored these policies, paying out damages on money that they lost to the famed schemer.

In fact, the company's problem with the Horowitzes lies not in the policy, but rather in their profit. According to AIG, the Horowitzes withdrew more money from their Madoff account than they originally deposited. Consequently, by demanding that the insurer cover their financial losses, the Horowitzes are, essentially, looking for a guarantee of the profits that they feel they are owed.

Given the history of AIG's business practices, even this isn't quite as far-fetched as it may seem. After all, a credit default swap (CDS), the financial instrument that got AIG in so much trouble, is basically a guarantee of profits against unforeseeable circumstances. In fact, CDSs are a fairly decent comparison for the current situation: in both cases, AIG's business model basically involved collecting never-ending premiums as it offered customers unlimited protection against unimaginable losses in a poorly-understood scheme.

The scary thing is, the Horowitzes may actually have a point. As repulsive as their argument is, their Fraud SafeGuard enrollment promised to cover their investment in Madoff. The insurance, at first flush, doesn't seem to mention dividends and, just because the Horowitzes actually profited from their Madoff dealings doesn't mean -- in concept -- that they have to suck up their eventual losses. If it promised to cover their principal, then AIG may find itself out the money that it agreed to insure.

In an ideal universe, AIG would have to cover the loss from its ill-conceived policy, while the Horowitzes would have to surrender their winnings to Elie Wiesel, whose charitable foundation Madoff defrauded. In this universe? They'll probably settle out of court.